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GBP vs Brexit: Why the pound is significantly undervalued

Publication Date: 08 Jan 2019 - By ReachX Team By ReachX Team
Actionable
Differentiated

FX & Rates FX EU ex-UK UK

The ongoing effects of Brexit uncertainty on pound have ensured the British currency is significantly undervalued, according to one City analyst.

In a recent note to clients assessing the impact of potential Brexit scenarios on the pound, Richard Falkenhäll, senior currency strategist at Nordic bank SEB, said the currency remains around 20% undervalued in trade weighted terms. 

“A call on the GBP is simply a call on what sort of Brexit the House of Commons will finally approve. According to our long-term valuation models for EUR/GBP, a fundamentally reasonable level for the currency pair would be around 0.75 instead of around 0.90, which is being traded today,” Falkenhäll said. 

Similarly, the two-year rate differential between the Euro area and the UK indicates that the currency pair should trade below 0.75. This suggests that the risk premium related to Brexit uncertainty and the potential negative consequences on the economy is almost 20% in EUR/GBP, according to SEB.

"The most likely outcome is that the Prime Minister Theresa May will be able to get some additional reassurances from EU leaders on the withdrawal deal that would convince MPs in her own party and perhaps some in the opposition still believing it is the right thing to honour the outcome of the 2016 vote (40% probability). 

“Were the House of Commons to pass the deal with the EU in January we expect a significant recovery for the GBP as this alternative then means the transition period will kick in from 30 March. However, uncertainty about the future will partly remain as negotiations with the EU on the future relationship will continue. Probably EUR/GBP would fall to around 0.82 in this case,” Falkenhäll added. 

However, if the UK were to withdraw without a deal and without a transition period (20% probability), the pound would probably fall significantly in 2019, even from current levels. 

“With the UK economy then most likely falling into a recession in 2019, we would expect the GBP to continue to fall. How much is of course extremely difficult to determine, but EUR/GBP would probably end up closer to parity in this scenario. In contrast, should the UK remain an EU-member – either by a decision by parliament to revoke Article 50 or a second referendum to give the electorate another chance to vote for the deal or to remain in the EU (30% probability) - we would expect a significant recovery in the GBP and EUR/GBP would then end up somewhere between 0.75 and 0.83.”

Falkenhäll said other alternative outcomes like Norway plus or to extend the withdrawal period to renegotiate the deal or to have time for a snap election would increase the likelihood that the UK will remain in EU. “Which is why we believe these low probability alternatives are combined with a stronger GBP. However, the short-term reaction in GBP in case the government was close to a no-confidence vote in the parliament would probably be negative.”

 

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